Over 400,000 people visited Farnam Street last month to learn howto make better decisions, create new ideas, and avoid stupid errors. With more than 100,000 subscribers to our popular weekly digest, we've become an online intellectual hub. To learn more about we what do, start here.

Is loss aversion’s existence moot?

Interesting paper on loss aversion.

This paper challenges the nature of loss aversion as we understand it.

Abstract
The principle of loss aversion is thought to explain a wide range of anomalous phenomena involving tradeoffs between losses and gains. In this article, I show that the anomalies loss aversion was introduced to explain — the risky bet premium, the endowment effect, and the status-quo bias — are characterized not only by a loss/gain tradeoff, but by a tradeoff between the status-quo and change; and, that a propensity towards the status-quo in the latter tradeoff is sufficient to explain these phenomena. Moreover, I show that two basic psychological principles — (1) that motives drive behavior; and (2) that preferences tend to be fuzzy and ill-defined — imply the existence of a robust and fundamental propensity of this sort. Thus, a loss aversion principle is rendered superfluous to an account of the phenomena it was introduced to explain.

* * * * *

So far, in this article, I have argued that the notion that motives drive behavior — together with the fuzzy and ill- defined nature of preferences — necessarily implies a ba- sic behavioral tendency to remain at the status-quo, with- out the need for any other auxiliary principle. I have also shown that this basic behavioral tendency is sufficient for explaining the existence of a status-quo bias, an endow- ment effect, and a risky bet premium, and that it provides a more logically consistent account for these phenomena than loss aversion.

Given this inertia account, what are the implications for the existence of loss aversion? To be sure, the existence of inertia does not preclude the possibility that other influences also contribute to the complex phenomena investigated in this article. Among those factors are anticipated regret, locus of attention, and the status-quo label bias. Other research, however, casts further doubt on the existence of a fundamental loss/gain asymmetry by challenging the evidence for loss aversion in phenomena that involve a loss/gain tradeoff but not a status-quo/change tradeoff. For instance, the equity premium puzzle — the finding that historical returns on stocks have significantly exceeded those on bonds (beyond what could be explained by simple risk aversion) — has previously been cited as evidence for loss aversion (Benartzi & Thaler, 1995). However, Fama and French (2002) noted that using historical data on returns alone is not very meaningful for judging the forward-looking equity premium — i.e., the returns investors could reasonably have expected at the time. Fama and French (2002) estimated the forward- looking equity premium to be substantially smaller than the realized equity premium, obviating the need for a loss aversion explanation.

Similarly, the scanner panel data finding by Hardie et al. (1993) that demand is more elastic for price increases than for price decreases was challenged by a study by Bell and Lattin (2000), who found no such asymmetry after controlling for the confounding influence of heterogeneity in consumer price responsiveness.

Even this evidence cannot disprove the existence of loss aversion; but, the inability of researchers to find evidence for loss aversion in these phenomena and its dispensability to an account of the phenomena it was introduced to explain — as highlighted by this article — do suggest that its existence may well be moot.